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Episode #049- The POWER of Negotiating Lease Renewals!

by Criterion, Braden Cheek, Brian Duck
February 14th 2022
00:00:00
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Today our hosts Brian Duck, Braden Cheek & Joel Thompson from The Criterion Fund talk about the power and importance of negotiating your own lease renewals.

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real quick. A sample of an option in a lease is, hey, this is a five year lease, but six months prior to my lease expiration, if I let you know I want to extend for another five years at that rate we discussed in the beginning, which is typically always at the advantage of the tenant because inflation is a bit much, then they get, they get to accept that they send you a letter and says, hey, we're gonna accept that option and uh our rent's gonna be cheap. But if, if they didn't have that option, there rent may be way more, could be way more. Yeah, it's really locking you in um and giving flexibility to the tenant because the tenants only going to take that if they can't find better space for cheaper. Uh And so did you, did you limit your negotiation by allowing them to have that option? So I'm not a huge fan of options, people you really, I mean, I think landlords like to offer them, but for me, because they think, oh, I got this, these options lined up for this tenant. I don't, I don't think that either at the end of the five years, either the businesses working or it's not working. And so if it, if it's not working, it doesn't matter how many options you have, they're not gonna take it.

And if the business is working, don't you want a chance to maximize the value in year 5? Hey, what's up guys? And welcome back to how to invest in commercial real estate. Today is an exciting episode. We are talking about commercial retail lease renewals and lease renewals as an owner is really where you get to impart value because a lot of the times, you know, you're, you're buying a shopping center, you're buying an existing lease that's already intact, It's a good investment, but you can't just go restructure those terms in the middle of it. You know, that's, that's a contract, that's an obligation. So you've got to wait until that lease expires and then at that point you really get the opportunity to go to the tenant and work out something new on, on, you know, a mutually beneficial terms, I guess. So today is all about the top five ways to maximize value in lease renewals before we get started. Let me ask a question, do we always want to take care of the lease renewals? Does does the management company ever do it? What's, what's our, what's our stance on that? Do you think that's a great question. Um, a lot of management companies do it. Most management companies take care of lease renewals.

I like to take care of my lease renewals because I, you know, I'm partial. I think I do a better job than they do, you know, a manager is, is typically working for a fee on a lease renewal, you know, which, which is fine, but I'm I'm owning the property, you know, and you can add, you know, potentially millions of dollars of value or just save yourself little heartaches along the way by reading least understanding the lease and getting those points in. And a broker may just be pushing the highest rent to get the biggest fee. You know, that's, that's what they're incentivized to do. So yeah, they're not incentivized to maximize uh profit for these renewals. Like we're gonna talk about today, right? Really. They just want their percentage, They want the highest monthly rent possible for the longest term because that's what their commissions based on. 100%. I have a couple of thoughts on that. Uh you know, we, I think handling your own renewal's does two things first is you negotiate that out of the management companies scope and now you're going to collect the real estate commission, let's say, or the fee based on that renewal.

So I don't, I don't see a reason to pay that to a third party unless it's just in a market that you are out of touch, you don't have any knowledge of and you already have someone handling the management and you say, hey, okay, handle the leasing renewal. But when you think about uh renewing leases, let's say it's a five year renewal and let's say the rate is $15 a foot um per year and it's 3000 ft. I'm not gonna do the math, but 90% or 95% of that. Uh that total that you're gonna, you're gonna pay that commission on is is just at $15. So the person that's that's handling the renewal for you. Whether they get 15 30 15 50 $16 on the renewal versus 15, it doesn't change their commission, but a couple of percentage points. But it really changes the value of your assets. Like we've talked about in previous episodes, you increasing the rent uh drastically increases the value of your property. And I'll give you an example and we'll talk about it later.

So every dollar that you increase your n oi If you plan on selling out of seven cap, you get $14 on your exit. Okay? And so the person that's renewing for you, that's getting a fee that doesn't really change whether they get a little more or a little less is just no one's gonna handle that release uh, lease renewal. Like an owner that's trying to maximize value. It just isn't gonna happen. So today we want to help you focus on, how do you take control if you do own uh, and maximizing value when you do your lease renewals and we want to encourage you to do your your own lease renewals. Yeah. So I think one of the biggest ones is getting tenants to pay a proportionate share of the costs associated with the center. And and very easily stated. That's called the triple nets of the deal. The triple nets are the common area maintenance. The insurance on the property and the property taxes for the property. So it's very normal for them to take a proportionate share of those expenses, if you have 10,000 ft and 100,000 square foot center, You should pay 10% of those associated expenses. But again, like we discussed in the beginning, a lot of times you're inheriting these leases, you're you're buying them already in place.

So that may not be there. And that's an easy way to maximize value. And it's, it's just an easy argument to be had. Pay the triple nets. Pay your associated expenses. Yeah. And so let's talk about why that's an important factor. You know, like you say, we've we've purchased properties where mom and Pops have owned and the leases are all over the board, there's no standard some tenants may cover, uh, you know, H. V. A. C. You know, sometimes that the tenant will cover the, you know, the landlord recover the 1st $1000 of the H. V. A. C. And then the tenant covers, Sometimes they cover roof structure parking, Sometimes they don't, sometimes they cover the taxes insurance, sometimes they don't. And so what it makes it hard is to figure out what the actual N. Oi is. And so when you have an asset that you're going to take to market, eliminating any guesswork on what the N. Y. Is going to be and uh, eliminating any risk to a potential buyer on uh, increasing cost is going to help maximize the value of your property. And so what we're talking about here is getting the tenant to sign up say, okay, we're switching you from a double net uh, to a triple net, which means kind of all encouraging expenses are now you're proportionate share.

What that does is then as those costs go up, real estate taxes, insurance, comedy maintenance, that burden falls back on the tenants collectively. And so it eliminates that risk for the landlord going forward that that's going to negatively impact is in the wind. That allows someone that's looking at purchasing it to really hammer in hone into his Ny? Yes. So there's there's there's different ranges of triple net, right? I mean there's kind of an absolute triple net where if anything happens to that building, the tenant occupying it is covering it, you know? And that that's what you would see on like a Single 10ant. Net lease. Yeah. Really, really popular. Like an army's out parcel. They they're maybe it's maybe an absolute net anything with that property, they cover, landlord covers nothing. So do you have to have that in the least whether it's an absolute net or triple that you still have to describe what that what that means. Right. Absolutely. A lot of times absolute triple nets are absolutely because they the tenant does everything themselves. So they pay the property taxes directly, they get insurance on the property directly and submit proof that it was done.

They take care of common area maintenance and and handle it directly. A triple net tenant in a shopping center may pay for all of the triple nets. Their their taxes, their insurance, common area maintenance, but they're handled by the landlord that takes a lot of time. You've got to go negotiate landscapers and take care of the roof and the maintenance and pay property taxes. Those need to be disputed almost every single year. You've got to get good insurance. You've got to get good insurance that isn't ridiculously expensive and again, there's a lot of value to be had there. Um, So you know, in exchange for that, it may not be unreasonable to start adding a fee on the triple nets. That's starting to become more and more common. We we do that. We had an administration fee of maybe 10 or 15% for us handling all the expenses, pro rating, the shares out. Um and so that that's an important part of it. It is okay. So uh what if the tenant says, Yeah, my my rent is $14. And now you want to add $4 more and triple nets, that's, that's a 25% increase. I can't, I can't stomach that for us.

We we realized that that may be a burden too much. And so we may say, okay, your, your rent was was 14 and there's $4 of triple nets. We'll, we'll go ahead and bill you now, we're gonna move it down to 11 50. Uh We're still gonna put those $4 on those. So your your total effective rent is going to be 15 50 but it's really 11 50 for the base plus those triple nets. And so that that gets them to be able to stomach it but going forward it and then it helps you maximize maximize his value. So it's just easier on the landlord and the investor to project cash flow. You you don't have the the swings of these repairs because you know the properties paying them over the years but then it's reconciled. So the tents are just paying the actual cost, their their their prorated share. Okay. The next area that we want to talk about and it's been a big one for us is annual compounding increases. You will get pushback from tenants that don't want this, they don't they don't want any increase and they don't want annual increases. What we see a lot is people saying, oh well okay, we we'll go flat for five years and then we'll give you a 10% bump in year six.

We want to encourage you not to do it that way. We think that the annual, small 2-3% annual increases every year is the best way to go. You know as you're waiting the rent staying the same for five years and inflation is going up. Why keep your income stagnant hit him with a 2% annual compounding not only will your rent be higher in your six if you do it that way, but each year your rent is higher. So you're getting a lot more profit along the way in the tenant. They're not really going to differentiate that much. The difference, you know, 2% a year versus inflation, which is higher. They're going to be like, Okay, that seems reasonable, 3% compounding to them. They don't understand how fast that's compounding. Uh And and so for us that's been a great tool to maximize value and then going back to Uh at a seven cap, every dollar you're getting on. That increases worth 14 on the exit. Well that's right. And if you decide to sell within those five years then you're in oi is higher in one particular year and you'll you'll get a higher sales price.

Right? For sure. Yeah, that's I mean that's that's a big one, that's a big, that's a big one. Any other thoughts? I mean besides uh this should be a definite focus is probably the most important point out of the five. It should have been number one in hindsight, but it doesn't matter getting more rent is the most important thing in any asset class, whether it's an apartment, it's industrial, it's retail, that's what's driving the value increase of the property. So you're assuming a sale at some point, you're assuming a higher sale at some point. And the only way you get that is compounding annual rent growth. It's the only way All right, so then you can get annual increases on on the renewal's. But another one our third point is always be willing to consider tenant improvement dollars in exchange for higher rent. And so a lot of the tenants, You know, their business is doing well, and let's say they're they're they're paying $15 a foot in rent and they could probably pay 15 16, 17, 18, but they're not going to pay any more than than we make them. But let's say they like, hey, I'm gonna sign a 55 year renewal, what's in it for me?

I'd like to, you know, fix this place up. I'd like to put some new light fixtures, some new flooring, some paint, maybe you say, okay, I'll offer you uh $10 a foot in T. I. So let's say it's a 25 100 square foot space, you're gonna offer him $25,000. And you know, t I, tenant tenant, improvement allowance dollars. And you say, okay, mr tenant, this lease is five years. So why don't we do this? Why don't we I'll give you the 25,000 interest free And you just pay instead of $15, you pay $17 for the next five years. That way I get my $10 back, you get interest free loan money that you can fix up your space and it's a net zero for both of us. Yeah but you keep saying fix up, you know their space but at the end of the day it's it's it's our space, you know what I mean? You're giving them money to invest in your building for sure. Uh And is it not not not even did did did you know it all shook out? Is it even? No it's not even okay. And why is it not even you gave 25,000 dollars to them?

And now and you've got 25,000 an extra rent over the next five years. But here's the thing is if you go to sell anytime in the next five years you're getting $2 more in rent times 2500 is $5000 times 14 on a seven cap. And it could be an eight cap and that's maybe 11 or 12 times. But let's just take 5000 times 14 eur 70,000 bucks In an in an additional you know, and you're still getting your 25,000 back. And another thing to keep in mind is at the end of that five years now uh instead of paying 15, guess what they're used to paying 17. And so now you can really leverage that they're already okay paying 17, you're not going to go back to 15. Their business can handle 17. So now you're going to start Annual increases on that 17 No. So you see you're winning on a couple of different fronts and giving them some tea I dollars selling it to them as uh an interest free loan to fix up their space. But you're getting the benefit on the back or potential benefit on the back end.

You know, it's an easy trap to fall into because if you've ever looked at buying a Starbucks or Chipotle or any other major brand, I mean the rent is gonna be astronomically high because all of the costs associated with that building are baked into the rent. And when you look, okay, worst case scenario, what happens if this tenant leaves, Which you should ask yourself that question, if you're buying something, what happens if the tenant leaves? Are you gonna backfill it for that amount of money Per, per foot? You know, Starbucks is leasing for you for $36 a foot. You're probably not going to get another coffee shop to pay $36 foot because it's already built out as a coffee shop. I mean it just, it doesn't, it doesn't work. Yeah. So be careful when you're buying a property where the rents are based on large T. I contributions. Okay, because it may be artificially high compared to the market and when that that lease is up, that tenant, Maybach say, hey, this is this rent is too high or you may have a hard time backfilling. Okay..4 is let's talk about options. Um you know, I see too many landlords that fall in love with giving tenants options as if it's a benefit to them.

Um and I don't see it as a benefit. Does it ever a benefit for the landlord? You know, I don't, I don't think it is because let's, let's say a tenant goes five years and they want an option to renew. Even if I say, Hey, I'm gonna, I'm gonna gouge him man in five years. I'm going to give them an option that's 30% higher than today. Well they can renegotiate it, they can renegotiate. They can say, you know what, I don't want that option. I'm out. I'm, I got a place down the street. The option holds no real value to a landlord because the tenant doesn't have to take it. So let's real quick, a sample of an option in a lease is, hey, this is a five year lease, but six months prior to my lease expiration, if I let you know I want to extend for another five years at that rate we discussed in the beginning, which is typically always at the advantage of the tenant because inflation is a bit much, then they get, they get to accept that they send you a letter and says, hey, we're gonna accept that option and uh our rent's gonna be cheap. But if if they didn't have that option there rent may be way more, could be way more. Yeah, it's really locking you in.

Um and giving flexibility to the tenant because the tenants only going to take that if they can't find better space for cheaper. Uh And so did you, did you limit your negotiation by allowing them to have that option? So I'm not a huge fan of options. People you really, I mean, I think landlords like to offer them, but for me, because they think, oh, I got this, these options lined up for this tenant. I don't, I don't think that either at the end of the five years, either the businesses working or it's not working. And so if it, if it's not working, it doesn't matter how many options you have, they're not gonna take it. And if the business is working, don't you want a chance to maximize the value in year five. Yeah, Because because let's say the market is, is doing really, really well, but you've already predefined your option so you can take advantage of it. And let's say the market is doing terrible. And she's like, well, I don't want to negotiate a new lease when the market's doing terrible. So I want to have options available. Well, he's not going to take your options, if the market is terrible, right? He's going to negotiate something else anyway. So it just isn't really a benefit to the tenants come to you very often asking for options, maybe the sophisticated ones do.

Yeah, The good ones should they should want to limit exposure uh in the future. So yeah, they want the options. So what I'm proposing is if you're gonna do options, be aggressive, Be really aggressive because it's only a benefit to the 10ant. Um So I have a different way. I just do fair market value options. It's so much easier because it's like, hey, if you want to renew, if you want a five year option renew, I mean it's basically worthless at that point. Like what is a 5-year option at fair market value? I mean, I guess you can put in, it is pretty subjective because what happens if you don't reach a conclusion on fair market value, what happens if you don't agree. I mean, you're basically just saying, hey, you know, I, I want to, I want a meeting that's pre designated to negotiate this. I think it's, it's okay to do that because in 98% of cases in the future, the fair market value of that rent is going to be higher than today. So you're gonna get an increase most of the time. Um And like you say, if push comes to shove, let's say the market isn't as good, you're at the end of the five years and the fair market value is less.

You can still argue about what that fair market value is to the point that you can, you can potentially get better than fair market value by just not agreeing. Um And some tenants may make you come up with a sophisticated appraisal process which kind of locks you in. But but worst case you could do a fair market value that at least will take care of inflation. Um And that that sometimes will in the tenants mind, oh fair market, okay that's fair, Fair is fair says it's fair right in the term and so they'll they'll kind of go ahead and let you do that versus locking yourself into something something worse. It makes me want to call the other option unfair option. You know if the tenants are allowed to say it's not fair, sometimes it can be unfair for the landlord if if you got you know 2 10 year options in your initial 10 year lease term and we're 30 years down the road and your rent is just pre negotiated, a stupid low rate. That's unfair to the landlord if you want to talk about fairness. And we have we have some tenants like that and we've we've had some big national retailers that have tried to lock us into 30 years of options with literally like 20% increase over 30 years.

So let's say The rent is $10 today per foot in 30 years, that should be $25 or $30. I mean I don't know in 30 years what the market's gonna do, just think about what prices were back in 1985. Do you think about what prices were six months ago? Yeah. And so, and, and they want, they want literally, Uh, five or 10% increases every five or 10 years. And so it's just not a good situation to lock yourself into that. You have to realize that those people negotiating those options are probably better at least negotiating than you because they're negotiating leases for 1000 stores across the US and all they do is negotiate hobby lobby leases. I mean, those people are asking for the moon because worst case scenario you say no. Yeah. And the, and the great, the big companies, they're just really good because of their leverage and their credit and the desire for people to have, let's say hobby lobby or whatever is that they will just stand their ground against you trying to negotiate a realistic, uh, you know, least schedule. And so we've, we've just had to tell him to take a hike, you know, but I know a lot of people do agree to it.

All right. Last one of the five is, is least term. So the normal thinking of a landlord is, hey, I want to get a long, the longest, least term possible. As long as possible. That's really what people say. And what people think now, what happens if, if you're gonna do that? Have you won What, what security did you actually buy yourself to me? Not that much. I mean, okay, especially if you're talking about second generation mom pop type retail businesses, restaurants and things. That's what we're talking about. Obviously if you lock into families another one resident. I mean large scale residential housing is another one. Yeah. I mean for us. Okay. So if I lock in a small retail tenant for 10 years now, I've paid 10 years of commission on that. And my question is, what did I actually do for myself? Because if the tenant bails, let's say the tenant's business doesn't work and their mom and pop and they're done in year three. How does, how does that help me? That I got a 10 year lease? It doesn't help me at all. Do they ever have personal guarantees on those leases where you could collect or is it always the company goes under and it's gone?

Yeah, you can uh if they have sometimes we have personal guarantees. But how much is that personal guarantee worth? How hard is it to go after them for the money if their if their business is failing at a 2500 square foot retail shops selling donuts? Like how much do you think that they are going to have for you to go after? Not that much. Okay, so the flip side to how I think about it is I kind of want shorter leases, Especially on new tenants that I'm not sure if they're gonna make it because for me, they're not going to be willing to pay as much per foot when they're first starting out because they're wary of their business working. And so okay, I'll give them a rate that gets them in there at $12 a foot. But if their business works and they're making money, they can afford $18 in a foot and rent. And so I want that chance in year three to evaluate how well they're doing and and to really go after a large increase once their business is established. But if I get a 10 year lease on a new tenant to me, I've, unless I get just really strong increases, which is unlikely I've limited myself on the upside.

If they're, if they're business, I'll give you an example. I've, I've done this uh marijuana business uh went into one of our centers And they had the leverage I had a large vacancy and they locked me in to a ten-year lease and I think I only got one or 2% uh increases. Their business is absolutely killing it. And I would love in a couple of years to be able to go back and increase that by 10 2030% because they can afford it. They're minting money, but I can't, I'm locked into a 10 year lease with minimal increases just because they were new, the space was big and I had some vacancy I wanted to fill. And so I wish I could go back there and redo that. And so I encourage people, unless it's a really strong credit that you're just guaranteed that you're gonna get paid the whole time. Think about negotiating shorter leases, evaluating how well the business does, and then negotiate to win when their lease comes up in 234 years anyway, yep, those are some good tips. Um, you know, when it, when it comes to adding value in commercial real estate investment, your least negotiation is the biggest spot to do it, hands down every single time you've got to read the lease, you've got to understand the least.

You've got to understand what your exposure is, their exposure is. And all of this will help you digest what a good lease rule is gonna be. We gave you some good tips today. Go out and implement in the next least rule. Hit us up with questions. Yeah, and we'll catch you next time. Thanks. Thanks guys.

Episode #049- The POWER of Negotiating Lease Renewals!
Episode #049- The POWER of Negotiating Lease Renewals!
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